The Rise and Fall of Long-Term Capital Management

Long-Term Capital Management was a hedge fund that made headlines for its extraordinary success and subsequent collapse. It was founded in 1994 by John Meriwether, a former vice-chairman of the Salomon Brothers investment bank.

The fund's strategy was based on complex mathematical models that predicted market movements with uncanny accuracy. Its initial success was staggering, with returns of over 40% in its first year.

However, the fund's success attracted a lot of attention and money, and it grew to manage over $100 billion in assets. This growth put a strain on the fund's systems and personnel.

In 1998, the fund's strategies began to unravel, and it suffered a series of large losses. These losses were exacerbated by a combination of market volatility and the fund's complex and interconnected positions.

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Long-Term Capital Management (LTCM) was founded in 1993 by John Meriwether, a former vice chair and head of bond trading at Salomon Brothers. He created the hedge fund after resigning from Salomon in 1991 amid a trading scandal.

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Meriwether recruited several top talent from Salomon, including Larry Hilibrand and Victor Haghani, who would become key players in LTCM's success. Two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton, also joined the team.

The company's founding team had impressive credentials, with many holding advanced degrees from top universities. For example, Myron Scholes held a Ph.D. from the University of Chicago, while Robert C. Merton had a Ph.D. from MIT.

Here's a brief rundown of the founding team:

The company was designed to have extremely low overhead, with trades conducted through a partnership with Bear Stearns and client relations handled by Merrill Lynch. This efficient setup allowed LTCM to focus on its core business: managing trades in the Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands.

Long-Term Capital Management's (LTCM) trading strategy was centered around finding pairs of bonds with predictable spreads between their prices. They would place bets that the prices would converge, or come back towards each other, when the spread widened.

Their core investment strategy was known as convergence trading, which involved using quantitative models to exploit deviations from fair value in the relationships between liquid securities across nations and between asset classes. This type of strategy was based on the Fed model-type strategies.

LTCM focused on US Treasuries, Japanese Government Bonds, UK Gilts, Italian BTPs, and Latin American debt, although their activities were not confined to these markets or to government bonds. They were the brightest star on Wall Street at that time, and their strategy seemed to be working well with initially strong returns.

As their capital base grew, LTCM faced challenges in deploying capital due to diminishing opportunities in the market. They turned to more complex strategies, including merger arbitrage and S&P 500 options, which were not traditional convergence trades.

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The collapse of Long-Term Capital Management (LTCM) was a devastating event that left many in the financial world reeling. In 1998, the chairman of Union Bank of Switzerland resigned due to a $780 million loss incurred from writing put options on LTCM.

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The bailout of LTCM was a massive effort involving a consortium of banks that lent the fund $3.6 billion. After the bailout, Long-Term Capital Management continued operations, earning 10% in the year following the bailout.

However, the collapse was devastating for many involved, including Mullins, who saw his future with the Fed dashed. The theories of Merton and Scholes took a public beating.

The credit crisis of 2008 hit JWM Partners LLC hard, resulting in a 44% loss from September 2007 to February 2009 in its Relative Value Opportunity II fund. This led to the shutdown of JWM Hedge Fund in July 2009.

John Meriwether, the founder of LTCM, launched a new fund called JWM Partners in 1999, which used less leverage than LTCM. However, it still suffered significant losses.

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Long-Term Capital Management's business model was built on making convergence trades, which involve taking advantage of arbitrage opportunities between securities that are incorrectly priced.

The fund focused on bond trading and was founded by John Meriwether, a renowned Salomon Brothers bond trader, and Myron Scholes, a Nobel-prize winning mathematician who developed the Black-Scholes model.

LTCM's strategy was to make trades that would profit from the convergence of prices, such as when interest rates changed and securities prices didn't yet reflect it.

The fund's assets grew from just over $1 billion in initial assets to approximately $5 billion by 1998, and it controlled over $100 billion in assets at its height.

LTCM also dealt in interest rate swaps, which involved exchanging one series of future interest payments for another, based on a specified principal among two counterparties.

To make money from these small spread arbitrage opportunities, LTCM had to leverage itself highly, with derivative positions worth over $1 trillion at its height.

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LTCM's Business Model was built around bond trading, starting with just over $1 billion in initial assets in 1994.

The fund's trading strategy focused on convergence trades, taking advantage of arbitrage opportunities between securities that were incorrectly priced relative to each other.

These arbitrage trades involved exploiting price discrepancies between securities that would soon converge once interest rates were accurately priced in.

An example of this would be a change in interest rates not yet reflected in securities prices, allowing for trades at values different from what they would soon become.

LTCM also dealt in interest rate swaps, exchanging one series of future interest payments for another, based on a specified principal among two counterparties.

High leverage was necessary due to the small spread in arbitrage opportunities, with the fund controlling over $100 billion in assets and having derivative positions worth over $1 trillion.

At its height in 1998, LTCM had approximately $5 billion in assets and had borrowed more than $155 billion in assets.

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LTCM was open about its overall strategy, but very secretive about its specific operations.

This secrecy made it difficult for investors to judge the risk involved in LTCM's trades.

The company scattered its trades among banks, adding to the opaqueness of its operations.

As a result, investors may have had an even harder time understanding the risks when LTCM moved into arbitrage involving common stocks and corporate mergers.

Since LTCM was flourishing, no one needed to know exactly what they were doing, and profits were coming in as promised.

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The UBS investment was a key component of LTCM's business model, allowing them to transform income into capital gains and take advantage of more favorable tax treatment.

Under prevailing US tax laws, LTCM was taxed at a higher rate on income than on long-term capital gains, which were taxed at 20.0 percent.

LTCM applied its financial engineering expertise to create a transaction with UBS that would defer foreign interest income for seven years, making it eligible for the lower capital gains tax rate.

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The transaction involved purchasing a call option on 1 million of their own shares valued at $800 million for a premium paid to UBS of $300 million.

This was completed in three tranches: in June, August, and October 1997.

UBS agreed to reinvest the $300 million premium directly back into LTCM for a minimum of three years.

To hedge its exposure, UBS also purchased 1 million of LTCM shares.

The net effect of the transaction was for UBS to lend $300 million to LTCM at LIBOR+50 and to be short a put on 1 million shares.

This deal made UBS the largest client of the hedge fund desk, generating $15 million in fees annually.

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The Long-Term Capital Management (LTCM) crisis was a pivotal event in financial history.

In 1998, the U.S. government had to step in and arrange a bailout to stave off global financial contagion, as LTCM's highly leveraged trading strategies failed to pan out and losses mounted due to Russia's debt default.

A loan fund, comprised of a consortium of Wall Street banks, was created to bail out LTCM in September 1998, enabling it to liquidate in an orderly manner.

This bailout was a significant event, as it highlighted the interconnectedness of global financial markets and the potential for widespread financial instability.

The Federal Reserve had to utilize federal money to bail out the creditors of LTCM, which saved the market in the short term but came under enormous opposition due to the use of public money to bail out billionaires who were taking risks.

The crisis led to a major re-evaluation of the use of financial models in decision-making, as the decisions made by these models can have disastrous consequences when market behavior deviates from normal.

Here are some key events and crises related to LTCM:

LTCM's collapse was a result of their narrow focus on short-term data, which drastically under-estimated the risks of a profound economic crisis. Historian Niall Ferguson pointed out that the firm's value at risk (VaR) models were based on just five years' worth of data, making them woefully unprepared for events like the 1987 stock market crash.

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Their use of VaR models also had several flaws, including excluding previous economic crises from their data sample. This made it impossible for the model to interpret extreme events like a financial crisis in terms of timing. This narrow perspective led to a lack of understanding of historical events, as even the firm's founder, Meriwether, admitted that living through the Depression would have given him a better understanding of events.

The consequences of LTCM's collapse were severe, with the U.S. government having to step in and arrange a bailout to stave off global financial contagion. A consortium of Wall Street banks created a loan fund to bail out LTCM, allowing it to liquidate in an orderly manner.

Long-Term Capital Management (LTCM) was a large hedge fund that promised huge returns to investors with its arbitrage strategy. It attracted about $3.5 billion of investor capital by the spring of 1998.

The firm was led by Nobel Prize-winning economists and renowned Wall Street traders. Its highly leveraged trading strategies, however, failed to pan out.

LTCM's value at risk (VaR) models, used to estimate potential losses, were based on only five years of financial data. This drastically under-estimated the risks of a profound economic crisis, as historian Niall Ferguson pointed out.

The firm's models would have captured the 1987 stock market crash if they had gone back eleven years. This highlights the importance of considering historical data when making financial models.

A VaR model is calculated based on historical data, but LTCM's model excluded previous economic crises such as those of 1987 and 1994. This is a crucial lesson for anyone using VaR models.

The U.S. government had to step in and arrange a bailout of LTCM in 1998 to prevent systemic contagion. A loan fund, comprised of a consortium of Wall Street banks, was created to bail out LTCM, enabling it to liquidate in an orderly manner.

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Mathematicians like Scholes, Merton, and Miller believed that the market is inherently random, and therefore, the only way to be successful is by understanding the science of randomness, i.e., probability.

Their formula, the Black Scholes formula, was used to price option contracts and became widely used in the market. Scholes received a Nobel Prize for this contribution.

The founders of Long Term Capital Management (LTCM) thought they could make risk irrelevant with dynamic hedging, which involves offsetting an open position's risk by creating a position with an opposite risk.

This strategy was based on algorithms that identified securities with opposite risks within nanoseconds across various markets.

Their approach was so confident that they believed they could eliminate risk altogether.

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